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Hello? Are you there? Hello?

Isn’t it annoying when you are having a delightful conversation with someone, one or both of you are on a cell phone, and in the middle of the call as you are talking you finish your thought and then…. nothing? Dead silence. “Hello? Are you there? Hello?” You look at the phone and it still says you are on the line with them. Grrr. You hang up, call them back and then try to figure out what they heard (if you can even remember where you were in the conversation!). Oh, the first world problems, as my son in the Army would say.

Well, last year was a delightful year in the markets. The friend on the other end of the line was a long-time trustworthy one. Their name? Diversification! Last year Diversification delivered on her promises of spreading the risk out across asset classes while providing solid returns everywhere. But, in January of this year, diversification went silent on us again. We hung up, dialed her back, but she didn’t answer. Is she ok? Has she passed away? Could it be that diversification was so 2017 and we’ve entered a new era of winner take all in the markets? Has it become a zero-sum game where a small number of U.S. equities are the only friend we have in the investment neighborhood?

We don’t think so because Diversification has been a trustworthy friend for so long. She has delivered at times when U.S. large companies (primarily Facebook, Amazon, Apple and Netflix) weren’t the darlings of the global markets like they have been this year (or at least they were until October!). There are periods when, believe it or not, emerging market stocks (Brazil and India as examples) handily beat the S&P 500. Likewise, international developed country stocks (like Europe and Japan) have done the same in the past. But Diversification can go MIA (missing in action) on us for extended periods of time. With that said, abandoning an old and trustworthy friend hasn’t been prudent in relationships or investing! So, obviously, that means in a year like 2018 when international stocks have lost money (almost 8% for developed and 12% for emerging ytd as of 11/2) and bonds are down because of rising interest rates (down almost 3%) our portfolios won’t look as good as last year. What, you might ask, does that mean going forward? That’s a very reasonable question and one I want to dig into a little. [1]

The Foggy Road Ahead

If we go back to January, most markets were up significantly in early January after a solid 2017. In January we decided to shift some additional allocation to international stocks. There were several reasons. First, the economic recovery in Europe and Asia from the financial crisis was slower than in the U.S. (which was painfully slow!). However, in January the outlook for those areas of the world was the best it had been in years and we were seeing real advances in economic output (which usually lead to greater profits which usually lead to higher stock prices). Second, the valuation delta, or difference, between international stocks and U.S. stocks was as large as it had been in many years. Much of that was because U.S. stocks had risen significantly higher than international stocks since 2009 despite the slow recovery here (even with massive and prolonged actions by the Federal Reserve) which caused valuations of U.S. stocks to enter altitudes they hadn’t seen since the dotcom bubble of the late 1990’s.

Fast forward to today and things look a lot different. International stocks, like U.S. stocks, shot up in early January, came down pretty hard that month, but unlike U.S. stocks never really staged a recovery to speak of. Economically, that rosy outlook and improving results overseas are now in tatters and the risks of a global recession have risen significantly. In fact, an economist who has been named the top forecaster for several years running by Bloomberg is saying the data overseas is eroding faster than other economists are giving credit and that their outlooks are still too optimistic.

Investment Implications

This scenario brings us to an interesting dynamic in investing and one that is difficult to get right. The dynamic I’m talking about is between 1) allocating a portfolio across multiple geographies and being patient while they wax and wane (including sizeable losses at times) knowing that our old friend, Diversification, doesn’t let us down in the end and 2) being cognizant of changes in the big picture and making adjustments to profit or protect depending on what those changes are. We usually do both but in varying degrees based on the circumstances. Our industry has people who advocate only doing 1 (like Vanguard) and people that only do 2 (like many hedge funds). Newsletter writer Steve Blumenthal recently put it like this and added some demographics to the two camps:

Plan 2: Seek growth while maintain a level of protection against 40-60% corrections. Open eyes, don’t panic, become greedy when others are fearful and fearful when others are greedy, stick to plan. (Best for 50 year-olds and older.)” [2]

I would agree with Steve because we know people who have said they just want to buy and hold low cost funds but panic and sell during market downturns because they have little to no protection built in. Over the past several years, index funds and index ETFs have garnered the lion’s share of inflows from investors. It’s easy to look back and say that was the best thing for many of them to have done. But looking ahead is very different. As Warren Buffet said, “The rearview mirror is always clearer than the windshield.” While the economy limped along recovering from the financial crisis at levels less than 3% per year, the Federal Reserve took interest rates to zero, leaving millions of Americans with almost nowhere to invest but the stock market to hope for any level of return. The point is that we are concerned that may people are vulnerable to a significant market downturn and would sellout at the wrong time. Addressing this vulnerability, another writer we follow claimed that people near or in retirement should hold only about 30% in stocks. And he was a trader! That may be a bit conservative, but his point should be taken to heart by you and me. The closer we get to being free from the need to work, the greater the magnitude a 40-50% decline in stocks becomes. I know those numbers seem drastic but remember the S&P 500 dropped 50.95% from October 2007 to February 2009. So yes, it can happen and did happen! Am I saying it’s about to happen again? Of course not. But we have to be mindful that while economic and market cycles aren’t often correlated with each other, the time they generally are is when things are the worst; a recession. Depending on the type of recession it is, stock markets are generally down 20-40%. That’s a big range but neither feel good.

Now What?

So, while we believe the U.S. still looks healthy right now with growth at levels we haven’t seen in over a decade, we are hopeful that despite lofty valuations the stock market can rebound from the recent downdraft in October and end the year in better shape. While the economic picture looks good for now, the market picture isn’t quite as clear because of valuations and because some analysts are concerned we’ve hit “peak earnings” meaning that corporate profits might be as good as we’re going to get for a while. Time will tell on that. On top of all that, the Federal Reserve is draining liquidity out of the markets by raising rates and shrinking its balance sheet. With that said, as I mentioned earlier the economic picture overseas has worsened quickly and pretty dramatically. So, we have cut back our exposure overseas and moved it back home, hoping to dampen the effect of a global recession (if there is one) while monitoring the markets and economy here. This move helped us take advantage of tax loss opportunities to offset some gains from earlier in the year for our clients with taxable (non-IRA) accounts.

The bond market has been a bit predictable this year in that rates were expected to rise meaning bond prices would come down. They have, faster than many people thought. Some key indicators of rates have broken down meaning that we could be on an upward path with rates for the foreseeable future. Unfortunately, as I stated at this year’s Half-Time event, most Fed rate tightening cycles end in a recession. At IronGate we still have exposure to bonds because while the risks of rates rising remains, we don’t believe the risk to portfolios is near as great in bonds as it is in stocks. So, bonds are still a portfolio shock absorber against equity market volatility for many of our clients. We took step years ago to lower our interest risk and that has helped us this year. We see the need for that continuing going forward.

The Big Picture

As always, there’s a lot going on in this unpredictable world in which we live. We could be at a tipping point at almost any time in any market because of how quickly things seem to change these days. We still believe our faithful friend Diversification will come through for us even when she goes MIA again like she has this year. We’re glad and thankful that our clients entrust us to oversee their wealth while also (and often more importantly) helping them with innumerable other financial decisions that come their way at any given time. Some of our retired clients want assurance they can afford that big family trip next year, while some of our younger clients are wanting our insight on major opportunities at their practice or company. Some of those opportunities involve buying while some involve selling. That constant dynamic is exciting while also requiring significant wisdom from a team of professionals. Often IronGate is the whole team, sometimes we are part of a team, and sometimes we are asked to assemble a team. We are fortunate to work with outstanding professionals in areas such as tax, legal, real estate and finance around the country. If you or someone you know needs help in any of those areas, we are here to help.

Pretty soon most people will turn their attention to the holidays and the chance to slow down a little. The IronGate team stays busy through December as there is a lot that goes on at the end of the year in the markets and our clients’ lives. But we also have lives outside of here and look forward to some downtime as well. With kids spread out across at least four states we are busy coordinating holiday schedules and who comes and goes when. With that said, we know the holidays are a difficult time for those who have lost spouses and other loved ones recently. Our area is still recovering from a hurricane and many are still suffering from it. But with all that, we have so much for which to be thankful. Please, let us know how we can help. It’s what we love to do!

IronGate Partners is registered with HighTower Securities, LLC, member FINRA and SIPC, and with HighTower Advisors, LLC, a registered investment advisor with the SEC. Securities are offered through HighTower Securities, LLC; advisory services are offered through HighTower Advisors, LLC.

This is not an offer to buy or sell securities. No investment process is free of risk, and there is no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is not indicative of current or future performance and is not a guarantee. The investment opportunities referenced herein may not be suitable for all investors.

All data and information reference herein are from sources believed to be reliable. Any opinions, news, research, analyses, prices, or other information contained in this research is provided as general market commentary, it does not constitute investment advice. The team and HighTower shall not in any way be liable for claims, and make no expressed or implied representations or warranties as to the accuracy or completeness of the data and other information, or for statements or errors contained in or omissions from the obtained data and information referenced herein. The data and information are provided as of the date referenced. Such data and information are subject to change without notice.

This document was created for informational purposes only; the opinions expressed are solely those of the team and do not represent those of HighTower Advisors, LLC, or any of its affiliates.